Accounting Terms You Should Know: Part 1

A lot of business owners cringe when someone mentions accounting.  The very word conjures up unpleasant memories of crunching numbers, guessing over month-end closing entries, and trying to get things to balance.  In a choice between spending time away from the business to work on the books and undergoing a root canal, working on the books might still win, but it would be close.

This is the first part of a series of five–or more, if the spirit moves us!--articles on accounting designed to give you just some of the basics.  These days, you’re more likely than ever to have an outside bookkeeper or an accountant looking at your books, and in fact Haven is working on automating more and more of the bookkeeping underlying your most common transactions, but it still helps to be fluent in the concept so that you can discuss them with your accountant or outside CFO.

Don’t get too worried, though; today is just tipping our toes in the water with the most basic concepts.

Assets

Your business’s assets are all of the things of value that your business owns or has a right to that help your business own revenue.  That includes everything from hard assets like real estate, equipment, and inventory to soft assets like your brand name and any other intellectual property that your business owns.

As the kids say, money doesn’t grow on trees, and revenue doesn’t show up without assets, either.  In order to have a viable business, you’ll need to acquire assets and use them to generate revenue.  But in the process of doing so, you’ll use up those assets and need to replace them.  For example, you can acquire inventory and sell it, and then that inventory is obviously gone.  Similarly, that machine in the back is an asset, too, and it’ll break down beyond all repair eventually.

A lot of your business planning will revolve around managing your asset base and the cost of replenishing it relative to the value that you can create from them, so always be thinking about what assets you need, what assets you don’t, and what you’re willing to pay for them.

Liabilities

As we said, the assets that you use to generate revenue for your business don’t come free–or even cheap, these days–and that means that you’ll need to finance their acquisition.  You can do that by putting your own money into the business or by raising money from others, either in the form of debt or equity.  But however you choose to finance those assets, that financing, even if it comes from you, will create a claim on the underlying assets of your business.  We call those claims liabilities.

Whoever finances a business has a right to get paid back, although the nature of that right–and your business’s corresponding liability–will depend on whether the financing was a form of debt or equity.  If the liability is a debt obligation, then the holder will have the right to get paid back out of the business’s cash flows or liquidating distributions before any holder of equity.  Anyone who holds equity–including you, if you put money into your business in exchange for stock, for example–will have a residual claim; i.e., the equity holder will get paid back only if there are any funds left over after the debt holder has been paid.  That’s why equity in a business is riskier than a debt interest in a business.

Owner’s Equity

Owner’s equity can sometimes be a bit of a red herring.  The fundamental accounting equation is that the value of a business’s assets is equal to the sum of the value of its liabilities and the value of its owner’s equity.  Through simple algebra, we can flip this equation around so that owner’s equity is equal to assets minus liabilities.  For that reason, a lot of people think of owner’s equity as another name for net worth.

That’s both true and false, depending on how you look at it.  It’s true in the sense that if you borrow money to acquire assets at fair market value, resulting in no net change to your owner’s equity, and then you sell some of those assets at a profit, then your owner’s equity will go up by the amount of profit that you recognized.  That sounds an awful lot like an increase in your net worth.

But that’s taking a backward-looking view of owner’s equity.  Owner’s equity is fundamentally not the same thing as what your business is worth.  Theoretically, a business should be worth the present value of the sum of all future cash flows that it’ll generate in the future minus the present value of all future liabilities that it’ll have to pay in the future.  That’s a forward-looking view of a business’s worth.  So make sure that you always think about owner’s equity merely as an historical scoreboard, not as a measure of what you could get if you tried to sell your business on the open market.

Revenue

Revenue is all the money you earn when you sell your goods and services.  It’s a gross number, not a net number, which means that we don’t subtract out any expenses from it.  (Those will come out later when we calculate earnings numbers lower down on the income statement.)

Revenue, also referred to colloquially as sales, is a good way of measuring aggregate demand for your goods and services.  If revenue’s going up, then even if you know you have problems somewhere else in the business, you know you must be doing something right or else the wind is just really at your back.  But if revenue is flatlining or falling, then you know either you’re doing something wrong or the market is switching away from your product.

A word of warning:  revenue is not cash.  You might have earned money because you sold someone a good or service, but maybe you sold it to them on credit and they still have to pay you.  You may be owed some amount of money, so that’s revenue, but if you don’t have it your hot little hand, then it obviously isn’t cash.  Revenue is an important metric, and we think that you should track it, but if you can’t stand to focus on one more metric on top of all the others that you currently track, then consider focusing on cash instead.  In a small business, cash is king, and a lack thereof is high on the list of things that might put you out of business.

Expenses

Whew!  Last item on our list today:  expenses.  You probably think of expenses as all of the costs that you face when running your business.  And that’s exactly right.  We’ll subtract your expenses from your revenue to get to your net income.  The higher your revenue and the lower your expenses, the bigger the smile on your face, right?

Right, but there’s a more technical way of thinking about expenses that we’d encourage you to adopt.  Expenses are a way of measuring the wasting away of your asset base as you convert those assets into revenue.  You acquire assets so that you can generate revenue, but you use up those assets in the process, so you have to go acquire more assets to be able to keep generating revenue.  When you keep that link in mind, it’ll help you start to see how you can measure various parts of your business model so that you can determine whether you need to make a change to it in order to keep it viable.

We’ll have more to say about that ongoing process of making adjustments to your business in future posts, but for now, just remember that there’s a distinction between working in your business and working on your business, and the more you can use your knowledge of accounting concepts to measure various aspects of your business, the better you’ll get at working on your business.